I write primarily about the U.S. public and private retirement system. Trained in economics (1999 PhD from MIT), I serve as the William Karnes Professor of Finance and Director of the Center for Business and Public Policy at the University of Illinois. I am also Associate Director of the Retirement Research Center at the National Bureau of Economic Research (NBER). Previously, I served as Senior Economist with the President’s Council of Economic Advisers, as staff to the President’s Commission to Strengthen Social Security, and as a Member of the Social Security Advisory Board. I am also a Trustee for TIAA-CREF, a Fortune 100 financial services firm serving the not-for-profit sector.

Why Retirement Plan Tax Preferences are Not as Expensive as You Might Think

Retirement plans such as the 401(k) receive favorable tax treatment under the U.S. income tax system. Historically, this favorable tax treatment was provided to increase individual saving. Recent research has called the efficacy of this approach into question, suggesting that individual saving rates may not be all that responsive to marginal tax rates.

Last week, I wrote about the danger of drawing the conclusion that tax incentives do not matter and that we should therefore look to eliminate the tax preference for retirement saving. My focus was on the role that tax preferences play in providing an incentive for employers to offer plans, and to design them in a way that uses behavioral nudges to increase saving.

This week, I want to focus on a different aspect of this issue, the public discussion of which has been misleading – how much this tax preference costs the U.S. Treasury. My contention is that the cost figures being bandied about (including my own use of the $100 billion figure in last week’s post) are substantially overstated. The point of today’s post is to note that the amount of revenue that the government would receive by eliminating the preferential tax treatment for retirement saving would be much less than what it might appear.

To understand this, one must understand (1) how retirement plans are treated under U.S. tax law, (2) how the government actually accounts for the foregone revenue, and (3) how the government ought to account for the foregone revenue. These are complex topics, but some simple exposition is sufficient for seeing the main point.

(1) How are retirement plans treated under U.S. tax law? In a nutshell, the income tax on retirement plan contributions is deferred, not eliminated. This is an important distinction. If I receive an additional $1000 in cash salary, and I am in a 35% tax bracket, I owe the government an additional $350 in taxes. If, however, I receive this additional $1,000 in the form of a contribution to a 401(k) plan, I owe no taxes today. However, I will owe taxes on the money when I withdraw it during retirement. Of course, there is financial value to deferring my taxes (what we economists call tax free “inside build-up”), but it is not as if the initial contribution escapes the tax system entirely.

(2) How does the government account for the foregone revenue? The U.S. Department of Treasury and the Congressional Joint Committee on Taxation prepare annual estimates of what they label “tax expenditures.” These tax expenditures are basically just an estimate of how much additional tax would be collected if a particular activity went from being untaxed to being taxed, assuming no behavioral response to the tax. (As an aside, the fact that they do not account for a behavioral response is why they are careful to always note that “a tax expenditure estimate is not the same as a revenue estimate.”) In the case of retirement plan contributions, they roughly calculate the amount of money being deferred, apply the relevant marginal tax rates to it, and obtain a rough estimate of how much revenue is not being collected as a result of this tax preference. However, a key point is that they do not estimate this over the entire life of the account, but rather use an arbitrarily truncated time horizon to estimate the effects.

Going back to my simple example: suppose I contribute an additional $1,000 today to a 401(k) plan. That saves me $350 in taxes today, and costs the government $350 in foregone revenue in the current tax year (assuming I would save the same amount either way). So far, so good. But suppose that I plan to pull the money out in 20 years. I will pay income taxes on the amount I withdraw. The present discounted value of the tax that I pay in 20 years will likely be less than $350, but it will be much greater than zero. For the sake of example, suppose it is worth $150 in present value. If so, then the net gain to me (and the net cost to government) over my lifetime is $200. The problem is that the government does not use a present value method. Instead, it looks at just the front end, and thus overstates the value of the deduction.

(3) How should the government account for tax expenditures? Ideally, the government would compute these tax expenditures using the “present value” concept just explained. A number of experts have made this suggestion. For example, a paper by the American Society of Pension Professionals and Actuaries (ASPPA) boldly states “tax expenditure estimates for retirement savings provisions should be prepared on a present-value basis” because this “would allow an ‘apples to apples’ comparison” with other tax deductions.

How does all this matter for policy? The fiscal cliff has DC policymakers scouring the four corners of the earth looking for ways to boost revenue without raising marginal tax rates. One way to do this is to eliminate tax expenditures. However, some of those tax expenditures exist for good economic reasons, and the provision of favorable tax treatment for retirement saving is one of them.

As noted last week, the elimination of this provision could have serious unintended consequences for the availability of retirement savings programs through employers. Now add to that the fact that any revenue implications of such a policy change are substantially overstated and what you get is the potential for good intentions (closing the fiscal gap) to lead to bad policy.

Relevant Disclosures: I serve as a trustee for TIAA, a provider of retirement plans to the not-for-profit sector. I have also received compensation as a consultant or speaker for a wide range of other financial services institutions. The opinions expressed in this blog (and any errors) are my own.

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I am going to hit the magic 70 1/2 age next year and start paying taxes on my 401k. IF the gov’t wanted more tax collection now, what about a program to allow 401k owners to either make withdrawals above the MRD at a discounted tax rate or prepay taxes at a discounted rate. Kind of like a Roth conversion with taking any money out.

It does seem that they ought to allow individuals to pay the tax according to the MDR schedule without actually having to withdraw the money. But my general complaint about the MDR’s is that they were written from the perspective of tax policy rather than retirement policy. If lawmakers had been focused on retirement income security rather than revenue raising, we would *not* require individuals to withdraw their money as quickly as we do. If people actually consume what they withdraw under some of the MDR rules, they will be in a world of hurt if they live into their 90s.

Why not get a reverse mortgage and take the proceeds out tax free? That way you escape uncle sam the whole way. To learn more check out this free resource I’ve put together for seniors to learn about reverse mortgages: www.ReverseFAQS.com

In addition, the lost revenue due to the inside build up not being taxed annually is not as great as one would expect. For example, if pension plans were eliminated, most of the money would be saved in stocks, where the unrealized capital gains aren’t taxed each year either (and dividends are taxed at a lower rate) or in real estate, tax-exempt municipals, etc. where even the realized gains aren’t taxed ever. From my time at Senate Finance, I know that Joint Tax Committee knows this and sympathizes. Like you, I wish Treasury and JCT would recognize this in their annual tax expenditures documents. I tried to get them to use the PV method you mentioned in all their work, when I was in Senate Finance, and I think JCT would do it, but I couldn’t get the top people in Senate Finance to support the idea.